Retained Earnings

And
Cost of debentures

Presented by
P. Madhuri
Prinkle Jain
Shersti Jain
 Retained Earnings
• Accumulates income that has been retained in the
business (that is, not paid out in dividends to
stockholders) over life of business.
• All net income - net losses - dividends
• Negative balance in Retained Earnings - deficit
-A net loss is recorded in Retained Earnings by a closing entry
in which Retained Earnings is debited and Income Summary is
credited.
 Cost of retained earning
• Cost of retained earnings (ks) is the return
stockholders require on the company’s common
stock.

There are three methods one can use to derive the

cost of retained earnings:
a)     Capital-asset-pricing-model (CAPM) approach
b)     Bond-yield-plus-premium approach
c)     Discounted cash flow approach
 (a)CAPM Approach

Example: CAPM approach

For Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of
retained earnings for Newco using the CAPM approach?

Answer:
ks = rf + bi (rm – rf) = 4% + 1.1(15%-4%) = 16.1%
 b)    Bond-Yield-Plus-Premium Approach
Formula

ks = long-term bond yield + risk premium

Example: bond-yield-plus-premium approach

The interest rate on New co’s long-term debt is 7% and our risk
premium is 4%. What is the cost of retained earnings for
Newco using the bond-yield-plus-premium approach?

Answer:
ks = 7% + 4% = 11%
 c)     Discounted Cash Flow Approach
Formula
ks = D1 + g;
        P0       

where:
D1 = next year’s dividend
g = firm’s constant growth rate
P0 = price Typically, you must also estimate g, which can be
calculated as follows:

g = (retention rate)(ROE) = (1-payout rate)(ROE)

• Example: discounted cash flow approach
Assume New co’s stock is selling for $40; its expected return on
equity (ROE) is 10%, next year’s dividend is $2 and the company
expects to pay out 30% of its earnings. What is the cost of retained
earnings for Newco using the discounted cash flow approach?

Answer:
g must first be calculated:
g = (1-0.3)(0.10) = 7.0%

ks = 2/40 + 0.07 = 0.12 or 12%

Prior Period Adjustments

Correction of a material error in reporting

net income in previously issued financial
statement
1) made directly to Retained Earnings.
2) reported in the current year’s
retained earnings statement
as an adjustment of the
beginning balance of
Retained Earnings
 Prior Period Adjustments
• Assume that General Microwave discovers in 2010that it understated
depreciation expense in 2009 by $300,000 as a result of computational
errors.
• These errors overstated net income for 2009, and the current balance
in
• retained earnings is also overstated. The entry for the prior period
• adjustment, assuming all tax effects are ignored, is as follows:

A DEBIT TO AN INCOME STATEMENT ACCOUNT IN 2010 WOULD BE

INCORRECT BECAUSE THE ERROR PERTAINS TO A PRIOR PERIOD
 Statement Presentation of Prior
Period Adjustments
Assuming that General Microwave has a
beginning balance of $800,000 in retained
earnings, the prior period adjustment is reported
as follows:
GENERAL MICROWAVE
Retained Earnings Statement (partial)
Balance, January 1, as reported $800,000
Correction for overstatement of net income
in prior period (depreciation error) (300,000)
Balance, January 1, as adjusted $500,000

REPORTING THE CORRECTION IN THE CURRENT YEAR’S INCOME

STATEMENT WOULD BE INCORRECT BECAUSE IT APPLIES TO A
PRIOR YEAR’S INCOME STATEMENT.
 Debits and Credits to
Retained Earnings
Retained Earnings

1.Net Loss 2.Prior 1. Net income

period adjustments for 2. Prior period adjustment for
overstatement of net income understatement of net income
3.Cash dividends and stock
dividends
4.Some disposals of treasury
stock

Many corporations prepare a retained earnings

statement to explain the changes in retained
earnings during the year.
 Retained Year
Retained Year

10,887.00

7,089.00

5,222.00
4,129.00

2,437.00

2,006.00 2,007.00 2,008.00 2,009.00 2,010.00

 Statement of Retained Earnings
• The Statement of Retained Earnings reports
how net income and dividends affected a
company’s financial position during the
period.
 Statement of Retained Earnings
• Note that the Income Statement must be
prepared before the Statement of Retained
Earnings.
• This is because you have to know the amount
of net income in order to compute the ending
balance of retained earnings.
 Order of Preparation

Income
Statement
Statement of Retained
Earnings Balance Sheet
Net income Beginning Retained
Earnings
+ Net income
– Dividends
Ending retained earnings Ending Balance
Retained
Earnings
 Review

 Income statement—A summary of the revenue and

expenses for a specific period of time.
 Statement of retained earnings – a summary of the
changes in the retained earnings that have occurred
during a specific period of time.
 Balance sheet—A list of the assets, liabilities, and
owner’s equity as of a specific date.
 Example Problem
Cash 5,000 Sales 100,000

Utility Expense 8,000 Buildings 65,000

Common Stock 45,000 Accounts Payable 12,000

Supplies 4,000 Cost of Goods Sold 58,000

Interest Expense 5,000 Additional Paid in 20,000

Capital

Bonds Payable 40,000 Supplies Expense 3,000

Salaries Expense 16,000 Accounts Receivable 10,000

Inventories 45,000 Retained Earnings 5,000 (beg. bal.)

Income Tax Rate 30%

 Step One
• Classify the accounts as assets, liabilities,
equity, revenue or expenses.
 Assets

Cash 5,000 Sales 100,000

Utility Expense 8,000 Buildings 65,000

Common Stock 45,000 Accounts Payable 12,000

Supplies 4,000 Cost of Goods Sold 58,000

Interest Expense 5,000 Additional Paid in 20,000

Capital
Bonds Payable 40,000 Supplies Expense 3,000

Salaries Expense 16,000 Accounts Receivable 10,000

Inventories 45,000 Retained Earnings 5,000 (beg. bal.)

Income Tax Rate 30%

 Assets, Liabilities,

Cash 5,000 Sales 100,000

Utility Expense 8,000 Buildings 65,000

Common Stock 45,000 Accounts Payable 12,000

Supplies 4,000 Cost of Goods Sold 58,000

Interest Expense 5,000 Additional Paid in 20,000

Capital
Bonds Payable 40,000 Supplies Expense 3,000

Salaries Expense 16,000 Accounts Receivable 10,000

Inventories 45,000 Retained Earnings 5,000 (beg. bal.)

Income Tax Rate 30%

 Assets, Liabilities, Equity

Cash 5,000 Sales 100,000

Utility Expense 8,000 Buildings 65,000

Common Stock 45,000 Accounts Payable 12,000

Supplies 4,000 Cost of Goods Sold 58,000

Interest Expense 5,000 Additional Paid in 20,000

Capital
Bonds Payable 40,000 Supplies Expense 3,000

Salaries Expense 16,000 Accounts Receivable 10,000

Inventories 45,000 Retained Earnings 5,000 (beg. bal.)

Income Tax Rate 30%

 Assets, Liabilities, Equity,
Revenues

Cash 5,000 Sales 100,000

Utility Expense 8,000 Buildings 65,000

Common Stock 45,000 Accounts Payable 12,000

Supplies 4,000 Cost of Goods Sold 58,000

Interest Expense 5,000 Additional Paid in 20,000

Capital
Bonds Payable 40,000 Supplies Expense 3,000

Salaries Expense 16,000 Accounts Receivable 10,000

Inventories 45,000 Retained Earnings 5,000 (beg. bal.)

Income Tax Rate 30%

 Assets, Liabilities, Equity,
Revenues, Expenses

Cash 5,000 Sales 100,000

Utility Expense 8,000 Buildings 65,000

Common Stock 45,000 Accounts Payable 12,000

Supplies 4,000 Cost of Goods Sold 58,000

Interest Expense 5,000 Additional Paid in 20,000

Capital
Bonds Payable 40,000 Supplies Expense 3,000

Salaries Expense 16,000 Accounts Receivable 10,000

Inventories 45,000 Retained Earnings 5,000 (beg. bal.)

Income Tax Rate 30%

 Income Statement
Sales 100,000

- Cost of Goods Sold -58,000

Gross Margin 42,000

- Operating Expenses -27,000

Income from Operations 15,000

- Non-operating Items -5,000

Income before Taxes 10,000

- Income Taxes -3,000

Net Income 7,000

 Income Statement

Sales 100,000

- Cost of Goods Sold -58,000

Operating expenses include:
Gross Margin 42,000

- Operating Expenses -27,000 Utility expense 8,000

Salaries expense 16,000
Income from 15,000
Operations Supplies expense 3,000
- Non-operating Items -5,000

Income before Taxes 10,000

- Income Taxes -3,000

Net Income 7,000

 Income Statement

Sales 100,000

- Cost of Goods Sold -58,000

Gross Margin 42,000

- Operating Expenses -27,000

Income from 15,000

Operations Non-operating items include:
- Non-operating Items -5,000
Interest expense 5,000
Income before Taxes 10,000

- Income Taxes -3,000

Net Income 7,000

 Income Statement

Sales 100,000

- Cost of Goods Sold -58,000

Gross Margin 42,000

- Operating Expenses -27,000

Income from 15,000

Operations
- Non-operating Items -5,000

Income before Taxes 10,000 Income taxes = Income before

taxes * Income tax rate
- Income Taxes -3,000

Net Income 7,000

10,000 * 30% = 3,000
 Step Three
• Prepare the Statement of Retained Earnings.

Beg. balance, retained earnings

+ Net income
- Dividends
End. balance, retained earnings
 Statement of Retained Earnings

Beginning Balance, 5,000

Retained Earnings Net Income is brought
+ Net Income +7,000 forward from the Income
- Dividends -0 Statement.
Ending Balance, 12,000
Retained Earnings
 Step Four
• Prepare the Balance Sheet.

Current assets
+ Non-current assets
Total assets
Current liabilities
+ Long-term liabilities
+ Stockholders’ equity
Total liabilities and
stockholders’ equity
 Balance Sheet

Current Assets: Current Liabilities:

Cash 5,000 Accounts Payable 12,000
Accounts Receivable 10,000 Long-term
liabilities:
Inventories 45,000 Bonds Payable 40,000
Supplies 4,000 Stockholders’
Equity:
Non-Current Common Stock 45,000
Assets:
Buildings 65,000 Additional Paid in 20,000
Capital
Retained Earnings 12,000

Total Assets 129,000 Total Liabilities 129,000

and Equity
 Balance Sheet

Current Assets: Current Liabilities:

Cash 5,000 Accounts Payable 12,000
Accounts Receivable 10,000 Long-term
liabilities:
Inventories 45,000 Bonds Payable 40,000
Supplies 4,000 Stockholders’ End. Bal. is
Equity:
brought forward
Non-Current Common Stock 45,000 from the
Assets:
Statement of
Buildings 65,000 Additional Paid in 20,000
Capital
Retained
Earnings
Retained Earnings 12,000

Total Assets 129,000 Total Liabilities 129,000

and Equity
COMPUTATION OF COST OF DEBT {Kd}

DEBT
IRREDEMA
BLE DEBT

REEDEMA
BLE DEBT
 IRREDEMABLE DEBT
IRREDEMABLE DEBT
FORMULA
FORMULA
1. Kd, before tax = I
------------
NP/Mpo
2. Kd, after tax = I [ 1- T ]
------------
NP
Were: Kd = Cost of debt, I = Interest Amount, T = Tax Rate,

Rv = Redemption value, Np = Net Proceedings [ issue price-flotation cost ]

N = No of years, Mpo = Current Market Price.
Example:
Example:
1. A 10% debentures, face value of Rs 100 each issued at
1. A 10% debentures, face value of Rs 100 each issued at
[a] 100; [b] 90; [c] 110
[a] 100; [b] 90; [c] 110
compute cost of debt, before tax @ 50%
compute cost of debt, before tax @ 50%
(1) With tax rate (2) with out tax rate ?
(1) With tax rate (2) with out tax rate ?
Solution: With tax rate With out tax rate
Solution: With tax rate With out tax rate
Formula Kd = I Kd = I (1-T)
Formula Kd = I Kd = I (1-T)
-------- ------------
-------- ------------
NP NP
NP NP
1. Kd = 10/100 = 10% Kd = 10 (1-0.5)/100 = 5%
1. Kd = 10/100 = 10% Kd = 10 (1-0.5)/100 = 5%
2. Kd = 10/90 = 11.11% Kd = 10 (1-0.5)/90 = 5.5%
2. Kd = 10/90 = 11.11% Kd = 10 (1-0.5)/90 = 5.5%
3. Kd = 10/110 = 9.09% Kd = 10 (1-0.5)/110 = 4.54%
3. Kd = 10/110 = 9.09% Kd = 10 (1-0.5)/110 = 4.54%
Note:- Tax shield on interest = Interest Tax Rate

Net interest = Interest – Tax shield on interest

Example:- 2 10% debentures, face value of Rs 100 each issued at 100 but repayable
After 5 years with Rs 10 assume tax rate 40%. Compute cost of debt ?

REEDEMABLE debt
REEDEMABLE debt
FORMULA

Solution: Kd = I (1-T) + Rv-NP/n I = Interest amount = 10

Solution: Kd-----------------------------
= I (1-T) + Rv-NP/n T I==Tax
Interest
rate =amount
40% = 10
-----------------------------
Rv + Np/2 RvT==Redemption
Tax rate = 40%
value = 110
Rv + Np/2 Np = Net proceeds =value
Rv = Redemption 100 = 110
Kd = 10 (1-40%) + (110-100)/5 n Np
= No= Net proceeds
of years = 5 = 100
n = No of years = 5
----------------------------------- = 7.6%
110+100/2

If FV, IP, RV = 100 Were:- FV = Face Value

Then Kd = CR(1-T) IP = Issue Price
RV = Redemption Value
CR = Coupon Rate
Kd = Cost of Debt
[O